Why Real Estate Investing for Cash Flow is Your Safest Bet
I’ve been accused on more than occasion of using too many acronyms. And more often than not it’s a fair accusation! You can blame it on a military father or too much time in the Big 5 Consulting ranks, but I could probably have an entire conversation in acronyms. Even if you aren’t talking to yours truly, there are so many acronyms flying around in Real Estate Investing it’s not easy to know which ones are important. Let’s spend some time discussing a wonderfully memorable and important acronym that can make you rich: CAPT
What Does CAPT Stand For?
CAPT denotes the different kinds of benefits that you can receive from real estate.
- C is for Cash flow.
- A is for Appreciation.
- P is for Principal Reduction.
- T is for Tax Benefits.
By owning and operating investment real estate you and your portfolio can realize one, if not all of these benefits.
What is Cash Flow?
Cash flow is the benefit you receive every month renting real estate of some type. Cash Flow is money that comes in every month. Assuming that your monthly cash flow is greater than your monthly expenses and debt service, the property will be cash flow positive. As a result, cash flow real estate investing is the safest way to ensure return on your investment.
What is Appreciation?
Appreciation is the benefit you receive when you sell your investment property for greater than what you paid for it (plus any improvements or expenses.) If you sold a home anytime before 2007, you no doubt experienced the benefit of Appreciation. It is often where you will make some of the largest sums of money in real estate. That said, Appreciation is also the most volatile (i.e., risky and prone to market fluctuations) aspect of CAPT. Many who have sold a home in the last year or so can attest to this first-hand. However several markets have bucked the trend and done quite well. We have had some good success in Texas, Oklahoma and Kentucky – just to name a few markets where we have had some nice Appreciation benefits in the recent past.
What is Principal Reduction?
Principal Reduction is the tried and true model of your tenant paying for your mortgage and principal payment every month. In essence, your tenant buys your property for you over time. Principal Reduction is more a function of loan term than anything else. You can accelerate Principal Reduction in your projects if you focus on loan assumptions of commercial property that are farther along in their amortization schedule. The only drawback to principal pay down is that you only recognize the benefit at liquidity events (i.e., sale, refinance, etc.)
What are the Tax Benefits of Owning Investment Real Estate?
The Tax benefits of owning investment real estate are nothing less than outstanding. Imagine owning a dividend stock with very little volatility that pays a 15% tax free dividend. Real estate as an asset class gets all the normal deductions of any investment business with the added benefit of a paper loss called depreciation. The net benefit is that depreciation as a paper loss can in many cases completely offset the cash flow from your investment property. In certain situations it can offset even more than your current cash flow and you can create a “depreciation bank” or use the excess depreciation to offset any other income.
Each investment will receive some benefit from each of the four areas but you will find the blend differs on the types of investments you are making. For example you won’t normally find high cash flow on a percentage return basis in the same investment as high appreciation potential.
Let’s compare California and Kentucky to explore this concept further. It’s almost impossible to get a cash-flow positive rental in San Francisco unless you put 50% down (even then it’s marginal.) In many parts of Kentucky you can find great property where you receive 15% to 20% cash on cash returns. California will experience higher appreciation (>10%) and devaluation (>30%) where Kentucky will motor along at a steady appreciation rate of 2% to 4% per year.
By looking at your investment projects through the CAPT lens, you’ll get much better at analyzing the benefit and the blend within your real estate portfolio. If you have a lot of cash-flow property but not enough depreciation, you could look at obtaining commercial properties which spin-off more depreciation because of their larger values. This is a great way to offset your taxable cash flow.
If you’re receiving an ROE (Return on Equity) of less than 10% in your real estate portfolio, what could you do to free up some principal to increase your rate of return? If you have a blend of properties across several asset classes, how do you know if you’re getting the best return on that portfolio? If you’re just getting started in Real Estate investing, where do you want to focus? What type of benefit could help you most now?
37th Parallel can help you get the right answers to all of these questions. If you want to learn more about CAPT, and how to apply its principles to your Real Estate Portfolio, please contact us today!